Collateralized debt obligations Definition
A cash flow collateralized debt obligation, or cash flow CDO, is a structured finance product that typically securitizes a diversified pool of debt assets. These assets, corporate loans for instance, are split into different classes of bonds that pay investors from the cash flows they generate.
Cash flow CDOs offer investors access to a diversified and actively managed portfolio of credit risks in a single investment that provides enhanced returns that correspond to each investors appetite for risk. Investors in CDO senior and mezzanine bonds can earn high returns relative to similarly rated asset-backed securities. CDO equity investors can earn leveraged returns.
Cash flow CDOs offer asset managers and issuing institutions a range of benefits, depending on the structure and motivation of each transaction. Asset managers can increase assets under management while locking in committed funds and achieving some protection from market value volatility. Issuing institutions can sell off portfolio credit risk, reduce regulatory capital requirements and lower funding costs.
Cash flow CDOs should be distinguished from market value CDOs, which are not discussed here. Whereas market value CDOs are managed to pay off liabilities through the trading and sale of collateral, cash flow CDOs are managed to pay off liabilities from the interest and principal payments of collateral. This means that unlike market value CDOs, cash flow CDOs focus primarily on managing the credit quality of the underlying portfolio rather than the volatility of its market value.